Can Royalties from K-1 offset passive losses from the same K-1 partnership?

This is actually a pretty interesting tax question! You're right to be digging into the regulations here. The key is understanding when royalty income can be considered part of the ordinary course of business versus when it's portfolio income. In your brother-in-law's situation, Treasury Regulation 1.469-2T(c)(3)(iii)(B) is definitely applicable. Since the partnership created the patents as part of their ordinary business operations after he invested, there's a strong argument that these royalties are not portfolio income but rather ordinary business income. When royalties are considered as derived in the ordinary course of trade or business, they can indeed offset ordinary business losses from the same activity. The partnership should be coding these correctly on the K-1, but sometimes partnerships don't properly characterize these items. What you'd need to do is request that the partnership amend the K-1 with the proper characterization of the royalty income as trade or business income rather than portfolio income. If they won't do that, you'd need to file Form 8082 (Notice of Inconsistent Treatment) with your brother-in-law's return, explaining why you're treating the royalty income differently than reported on the K-1. The goal is to have the income properly characterized so it falls within the same activity basket as the losses, allowing them to offset each other.

I used taxr.ai when I was in almost the exact same situation last year! My parents own about 25% of a medical device company (passive investment) and their K-1 showed business losses plus royalty income from patents. The partnership accountant insisted the royalties were portfolio income even though the patents were developed after they invested. I uploaded the K-1 and partnership agreement to https://taxr.ai and their analysis confirmed that royalties from patents developed as part of the partnership's regular business activity should be characterized as trade or business income, not portfolio income. They pointed me to the exact same Treasury Regulation you found (1.469-2T) plus several tax court cases that supported this position. It saved me hours of research and gave me the confidence to recharacterize the income properly. The detailed report they generated was super helpful when I had to explain my position to the partnership's accountant too!

I just wanted to follow up on my K-1 royalty/passive loss situation. After asking about taxr.ai here, I decided to give it a try since I was up against the filing deadline. Uploaded my documents Friday night and had a comprehensive analysis by Saturday morning! The report confirmed exactly what was discussed here - since the partnership developed the patents after I invested and as part of their regular business, the royalty income should be characterized as ordinary business income, not portfolio income. They cited Treasury Regulation 1.469-2T(c)(3)(iii)(B) and provided examples of similar situations from tax court cases. What I really appreciated was the step-by-step instructions for how to complete Form 8082 correctly and exactly which boxes to check and explanations to provide. Made the whole process much less intimidating. Just filed yesterday and feeling confident that if any questions come up, I've got solid documentation to support the position. Just wanted to share in case anyone else runs into this specific K-1 situation in the future!

Anyone else finding it impossible to actually speak with someone at the IRS about this kind of complex K-1 issue? I've been trying for weeks to get clarification on a similar royalty/passive activity situation, but keep getting stuck in phone tree hell or disconnected after holding for 2+ hours. I finally had success using https://claimyr.com - they held my place in line with the IRS and called me back when an agent was actually available. You can see how it works here: https://youtu.be/_kiP6q8DX5c Got connected with a surprisingly knowledgeable agent who confirmed that royalties from patents developed in ordinary course of business should be classified as business income rather than portfolio income. She pointed me to the exact section in the regulations and explained how to document my position if the partnership wasn't willing to amend the K-1. Honestly thought this service wouldn't work, but it saved me from wasting another day on hold. Just passing this along since this K-1 royalty situation seems to need actual IRS guidance.

Well I have to eat my words about the IRS help line. After seeing the post about Claimyr, I decided to try it myself for a similar K-1 royalty issue I've been struggling with. Got connected to an IRS agent within about 45 minutes (would've been HOURS of hold time otherwise). The agent was actually super helpful and confirmed that royalties from patents developed during ordinary business operations should generally be classified as business income, not portfolio income if the entity created the intellectual property. He directed me to check box 1 on Form 8082 and include a detailed explanation citing Treasury Regulation 1.469-2T(c)(3)(iii)(B). I was 100% convinced this would be a waste of time and I'd get some generic "consult a tax professional" answer. Instead, I got actionable guidance that aligned with what others have said here. Sometimes being wrong feels pretty good!

One thing nobody has mentioned yet is that the K-1 might already have the information coded correctly, but you're misinterpreting it. On the K-1, royalties can be reported in box 11 with various codes. If the royalties are truly portfolio income (from IP developed outside normal business), they should be in box 11 with code E. But if they're part of the business income, they might be included in box 1 already (net of expenses) or broken out separately with a different code. Check the K-1 footnotes/statements carefully. The partnership might have already classified them correctly, and you're just not seeing how the numbers flow together. Had this exact issue last year where the client thought they were being double-taxed, but the K-1 was actually correct.

Does anyone know if this same principle applies to S-Corp K-1s as well? My situation is similar but with an S-Corp that develops software and licenses it. The royalties are reported separately from business income on my K-1, but the software was developed as part of the company's normal business. Wondering if the same Treasury Regulation would apply?

This is a great discussion on a complex area of tax law! I wanted to add one practical consideration that might help others in similar situations. When dealing with partnerships that are reluctant to amend K-1s (which seems common based on the comments here), it's worth getting any conversations with the partnership's accountant in writing. If they verbally acknowledge that the patents were developed in the ordinary course of business after investment, ask them to confirm that in an email. This documentation becomes crucial if you need to file Form 8082 or if the IRS questions your position later. I've seen cases where partnership accountants give verbal guidance but then claim they never said it when push comes to shove. Also, for anyone considering the Form 8082 route - make sure you're confident in your position before filing. While it doesn't automatically trigger an audit, it does create a paper trail that could lead to scrutiny down the road. The key is having solid documentation supporting why the royalties should be characterized as business income rather than portfolio income. The Treasury Regulation cited throughout this thread (1.469-2T(c)(3)(iii)(B)) is definitely the right starting point, but each situation is fact-specific based on when the IP was developed and under what circumstances.